The following post comes to us from Frederick Wertheim, partner focusing on investment management and broker-dealer regulation at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication.

On June 5, 2013, the SEC voted unanimously to propose alternatives for amending rules that govern money market mutual funds under the Investment Company Act of 1940. Two alternative reforms to rule 2a-7 under the Investment Company Act of 1940 could be adopted separately or combined into a single reform package:

Alternative One: Floating Net Asset Value (“NAV”): The proposal would require all institutional prime money market funds to sell and redeem shares based on the current market value of the fund’s portfolio securities, rounded to the fourth decimal place, rather than at a $1.00 stable share price. Retail and government money market funds would be exempt from the floating net asset value requirement and would be allowed to continue using the penny-rounding method of pricing to maintain a stable share price but would not be allowed to use the amortized cost method to value securities.

Alternative Two: Liquidity Fees and Redemption Gates: Money market funds, other than government money market funds, would be required to impose a 2% liquidity fee if the fund’s level of weekly liquid assets fell below 15% of its total assets, unless the fund’s board of directors (a “Board”) determined that it was not in the best interest of the fund or that a lesser liquidity fee was in the best interests of the fund. After a fund has fallen below the 15% weekly liquid assets threshold, the Board would also be able to temporarily suspend redemptions in the fund for no more than 30 days in any 90-day period.

Additionally, the proposal contains a number of other reforms related to diversification of portfolio assets, enhanced stress testing and expanded disclosure and reporting requirements that would apply under either alternative. The proposal is subject to a 90-day comment period following publication in the Federal Register. [1]

Proposals

Background

Money market mutual funds (“MMFs”) must register under the Investment Company Act of 1940 (“ICA”), which imposes regulatory requirements on all mutual funds. Rule 2a-7 under the ICA (“Rule 2a-7”) [2] permits an MMF to maintain a stable NAV by valuing its portfolio securities at acquisition cost with adjustments for amortization of premium or accumulation of discount, or by rounding the MMF’s share price, typically $1.00 per share, to the nearest penny.

The Financial Stability Oversight Council (“FSOC”) previously proposed to make a determination that the conduct, nature, size, scale, concentration and interconnectedness of MMFs’ activities and practices could create or increase risk of significant liquidity and credit problems spreading among bank holding companies, nonbank financial companies and United States financial markets (“systemic risk”). Additionally, the FSOC proposal presented for comment three potential reforms to MMFs: floating NAV; stable NAV with a buffer and minimum balance at risk; and stable NAV combined with a buffer and other measures. [3] In the release, the SEC proposes reforms to Rule 2a-7 to address, primarily, what it views as a susceptibility of MMFs to heavy redemptions in times of low liquidity. While Alternative One in the SEC’s proposal involves a floating NAV for institutional prime MMFs, the SEC did not seek to implement either of the two alternatives requiring capital buffers suggested by the FSOC. Rather, the SEC’s proposal states that it views those alternatives as potentially costly for MMF shareholders and potentially harmful to the MMF industry because they could result in a contraction in the industry that could harm short-term financing markets and capital formation to a greater degree than the SEC proposals.

Proposed Reforms

The SEC seeks comment on two proposals to amend the rules governing MMFs that are intended to address MMFs’ purported susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks. In particular, the SEC identifies an incentive in times of financial stress, created by a stable MMF share price and heightened by liquidity concerns about the fund, for MMF investors to redeem shares ahead of other investors, because shareholders who redeem their shares before the fund “breaks the buck” will receive the full $1.00 share price despite the fact that the market-based value of each share may be less than $1.00. The SEC proposals, therefore, target the valuation and pricing methodology of MMFs and seek to provide Boards with more tools to address the consequences of illiquidity and the potential for runs as well as providing further transparency into MMFs.

Alternative 1: Floating Net Asset Value

Under the first alternative, MMFs (other than government MMFs and retail MMFs, both as described further below) would be required to float their NAVs, thereby forgoing a stable $1.00 price per share and reflecting more precisely and clearly the market value of the securities underlying the fund. Specifically, MMFs subject to this alternative would lose the ability to use amortized cost valuation [4] and penny-rounding pricing of their portfolios in order to maintain a stable share price. As a result, the share price would fluctuate based on the market value of a fund’s portfolio of securities. This floating NAV would also be required to employ “basis point” rounding, in which numbers are rounded to the nearest 1/100th of one percent (i.e., $1.0000 or an equivalent level of precision if a fund prices its shares at a target level other than $1.00) in an effort to make share prices more transparent with respect to small fluctuations in the value of a fund’s portfolio securities.

This alternative would only be applicable to institutional prime MMFs, and retail MMFs and government MMFs would be exempt from its provisions. In contrast, retail MMFs and government MMFs would be permitted to continue to maintain a stable share price through the use of penny rounding but would be unable to use amortized cost valuation. The proposal defines a government MMF as any MMF that holds at least 80% of its assets in cash, government securities [5] or repurchase agreements collateralized with government securities. A retail MMF is defined as any MMF that limits a shareholder of record [6] from redeeming more than $1 million in any one business day. Uncertainty concerning the definition of “institutional” MMF was at issue in the 2009 proposals that resulted in the 2010 amendments to Rule 2a-7 and the proposal explicitly recognizes potential difficulties in applying this test to omnibus accounts. The release suggests that possible solutions may include increased transparency by omnibus accounts or an arrangement by which the omnibus account holder imposes the $1 million limitation on its underlying shareholders and requests comments. Additionally, the SEC noted some operational problems in proposing an exemption from the floating NAV for retail MMFs, suggesting, for example, that prime MMFs currently having both institutional and retail share classes would have to reorganize into two separate funds (retail and institutional) in order for the retail fund to be within the retail fund definition.

Although the proposal would prohibit institutional prime MMFs from using the stable pricing provisions of Rule 2a-7, several other current requirements would remain. For example, MMFs would still be limited to investing in short-term, high-quality, dollar-denominated instruments, [7] and fund sponsors would be permitted to continue to support MMFs (subject to new disclosure rules), which could lessen the impact of a deterioration in a floating NAV.

Alternative 2: Liquidity Fees and Redemption Gates

The second proposed alternative would permit MMFs to maintain a stable share price provided that, if an MMF’s weekly liquid assets fell below 15% of its total assets, the MMF would be required to institute a liquidity fee (subject to certain Board determinations), and the Board would also have the ability to implement redemption gates. Consistent with the first alternative, MMFs would not be permitted to use the amortized cost method of valuation but would be required to penny round. As a result, MMFs would have to price their portfolios daily. Additionally, a drop in a fund’s level of weekly liquid assets would trigger the liquidity fee requirements and give the Board the ability to temporarily suspend redemptions.

Liquidity Fees. Other than government MMFs, MMFs would be required to impose a 2% liquidity fee on all redemptions if the MMF’s level of weekly liquid assets [8] fell below 15% of its total assets. The fee would be lifted automatically once the MMF’s level of weekly liquid assets reached or exceeded 30% of its total assets. The Board, once the trigger level had been reached, would have discretion to (i) not impose the 2% default fee rate or (ii) impose a lower fee rate, subject to a determination by the Board (including a majority of its independent directors) that, in the case of (i), such a fee would not be in the best interests of the fund or, in the case of (ii), that a lower fee would be in the best interests of the fund. Thereafter, the Board would also have the discretion to modify or remove the fee at any time that it (including a majority of its independent directors) determined that a different fee should be imposed or that imposing the fee is no longer in the best interests of the fund. The purpose of such fee, according to the SEC, is to (A) curtail the level of redemptions, (B) at least partially cover liquidity costs incurred by funds and (C) potentially repair the NAV of funds that have suffered losses. The SEC chose a default liquidity fee rate of 2% both because it was within a range suggested by commenters and because it believed that a liquidity fee set at that level was high enough to “impose sufficient costs on redeeming shareholders to deter redemptions in a crisis, but low enough to permit investors who wish to redeem despite the cost to receive their proceeds without bearing unwarranted costs.” The proposal makes the liquidity fee, rather than the redemption gate described below, a default because the SEC believes fees to be less disruptive as they still allow shareholders to continue to transact in times of stress.

Redemption Gates. After a fund falls below the 15% weekly liquid assets threshold, the MMF’s Board (including a majority of its independent directors) would be allowed, but not required, to temporarily suspend redemptions by the fund for such period of time as the Board deems necessary, up to 30 days in any 90-day period. The gate would be lifted automatically once the MMF’s level of weekly liquid assets reached or exceeded 30% of its total assets, although, consistent with the discussion above, the Board (including a majority of its independent directors) would be able to lift the gate upon a determination that doing so was in the best interests of the MMF. Redemption gates would serve a slightly different purpose than liquidity fees; specifically, the SEC believes they would help by stopping redemptions long enough to allow (i) managers time to assess the appropriate strategy to address redemptions, (ii) liquidity buffers to grow within the fund as portfolio securities mature, and (iii) shareholders to assess the level of liquidity in the fund and for any shareholder panic to subside.

Additionally, an MMF would be required to promptly disclose that it crossed the 15% weekly liquid assets threshold, the imposition and removal of any fees or gates, and the Board’s analysis with respect to the fees or gates. Further, although a government MMF would not be required to implement liquidity fees and redemption gates, its Board could choose to impose such requirements consistent with the SEC’s proposal.

Combination of Both Proposals. The proposal also contemplates the adoption of both alternatives, which would require MMFs (other than government MMFs and, with respect to the floating NAV, retail MMFs) to use a floating NAV and potentially impose liquidity fees or gates in times of financial stress.

Other Proposals

Disclosure. Each alternative reform proposal would amend current disclosure requirements to improve the transparency of the perceived risks present in MMFs, which would be mandatory in order for a fund to rely on Rule 2a-7. The revised disclosure rules include a new current event disclosure form (Form N-CR) that would require MMFs to publicly disclose certain events depending on which reform alternative is implemented, including portfolio security defaults, sponsor support, a fall in weekly liquid assets below 15% of total assets and a fall in the market price of the fund below $0.9975 for stable value funds. Additionally, MMFs would need to disclose, in some cases on their websites and in other cases in fund disclosure documents, among other things, depictions of the NAV per share, as well as disclosure regarding financial support received by the MMF.

Improved Private Liquidity Fund Reporting. The SEC also proposed to amend Form PF to require a “large liquidity fund adviser,” which is a liquidity fund adviser managing at least $1 billion in combined money market fund and liquidity fund assets, to report substantially the same portfolio information on Form PF as registered money market funds would report on Form N-MFP.

Diversification. The diversification requirements in Rule 2a-7 would be tightened by requiring, among other things, consolidation of affiliates for purposes of the 5% issuer diversification requirement and removing the 25% basket that permits MMFs to only comply with the 10% guarantee concentration limit with respect to 75% of the fund’s assets. Additionally, in many cases, MMFs would be required to aggregate all of the asset-backed securities vehicles sponsored by the same entity for purposes of the 10% guarantor diversification limit.

Stress testing. The proposed reforms would require that MMFs stress test against the fund’s level of weekly liquid assets falling below 15% of total assets.

Proposed Transition Periods. The SEC proposes transition periods for compliance with any amendments that differ depending on the proposal to which the amendment relates. MMFs would not be required to comply with amendments implementing a conversion from a stable NAV to a floating NAV until two years from the effective date of such amendment. Amendments related to the liquidity fees and gates would become effective one year following the effective date. Finally, any amendments not specifically related to either proposal would become effective nine months from the effective date.

Request for Comment

The SEC requests comment on the merits of the proposals as well as the benefit and drawbacks to combining the two alternative reforms and empirical data to support any comments. Specifically, the SEC seeks comment regarding, among other things, the effect the proposed alternatives would have on shareholders’ incentives to redeem shares in times of market stress; the effect of the proposals on transparency; different methods for distinguishing between government, prime institutional and retail MMFs; the impact of certain exemptions to the proposals, such as exemptions for retail MMFs, on competition, efficiency and capital formation; and transition periods for compliance. The comment period will last for 90 days after publication of the proposing release in the Federal Register.

Implications for Boards

Although the proposals would impose mandatory changes to how MMFs operate, such as the move away from amortized cost valuation, the second proposal gives MMF Boards discretion to determine whether to take any action regarding liquidity fees and suspension of redemptions. Although the proposal defaults to the requirement that MMFs impose the 2% liquidity fee when weekly liquid assets fall below the threshold, the Board may choose not to impose the fee or impose a lesser one. Indeed, the SEC has even proposed some factors that the Board might consider in determining whether to impose a liquidity fee once the fund’s weekly liquid assets have fallen below 15% of its total assets, noting that:

[f]or example, it may want to consider why the level of weekly liquid assets has fallen. Is it because the fund is experiencing mounting redemptions during a time of market stress or is it because a few large shareholders unexpectedly redeemed for idiosyncratic reasons unrelated to current market conditions? Another relevant factor to the fund board may be whether the fall in weekly liquid assets has been accompanied by a fall in the fund’s shadow price. The fund board also may want to consider whether the fall in weekly liquid assets is likely to be very short- term. For example, will the fall in weekly liquid assets be cured in the next day or two when securities currently in the fund’s portfolio qualify as weekly liquid assets?

Moreover, the ability to suspend redemptions following a drop in weekly liquid assets is just that – an ability, not an obligation. Although the level of discretion provided by the second proposal affords MMFs significant flexibility when faced with declining liquidity and increased redemptions, it also imposes on directors a great responsibility to make difficult decisions in stressful conditions with possible consequences not only for the fund and its shareholders but also for Systemic Risk.

[4] MMFs would still be able to use amortized cost valuation to the extent other mutual funds are able to do so under the ICA. For example, mutual funds are generally able to use amortized cost valuation where the fund’s Board determines in good faith that the fair market value of debt securities with remaining maturities of 60 days or less is their amortized cost.(go back)

[5] The term “government securities” would be defined consistently with section 2(a)(16) of the ICA, which defines a “government security” as “any security issued or guaranteed as to principal or interest by the United States, or by a person controlled or supervised by and acting as an instrumentality of the Government of the United States pursuant to authority granted by the “Congress of the United States; or any certificate of deposit for the foregoing,” and specifically would exclude securities issued by state and municipal governments.(go back)

[6] The proposed rule provides that an MMF may permit a shareholder of record that is an omnibus account holder to redeem more than $1,000,000 per day if such shareholder and the MMF have policies and procedures reasonably designed to prevent beneficial owners holding through such shareholder from redeeming more than $1,000,000 per day.(go back)

[8] Weekly liquid assets generally include cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, and securities that convert into cash within one week.(go back)